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Wednesday, January 6, 2016

Definitive Story on Subprime Fraud Ignored 11 Years Ago

The Stuff Happens school of economic thought likes to whitewash the magnitude of fraud by invoking the standard cliches--excess liquidity, tail risk, Black Swan scenario, irrational exuberance, we all drank the Kool Aid, remember the tulip craze--to dismiss any empirical review of culpability.

The antidote to this doublespeak remains the seminal reporting done by Mike Hudson and Scott Rekard in The Los Angeles Times on the boiler rooms at Ameriquest Mortgage Company.

Ameriquest became the leader in subprime lending, specializing in cashout refinancings with two-year teaser rates, and led the race to the bottom in credit standards. Others followed Ameriquest's lead. At the time, the legion of stories about the company's dishonest business practices were ignored by government officials because the company and its owner, Roland Arnall, were the largest donors to the campaigns of George W. Bush and Arnold Schwarzenegger. (Ameriquest was overseen by regulators in its home state, California.)

The essence of the mortgage crisis was simple. People broke the law because they knew they could get away with it. High ranking government officials thwarted efforts to police against fraud. And when interest rates started rising, Arnall saw the writing on the wall and began to shut down and sell off his operation. And then he got Bush to appoint him Ambassador to the Netherlands.

As I wrote five years ago, the article exposes the wilfull blindness at the heart of the crisis:

Past is prologue, and everything you need to know about the financial meltdown can be gleaned from a single article published more than five years ago in The Los Angeles Times. The 3,200-word piece tells you nothing about credit default swaps or CDOs or hedge funds or AIG. There’s no need to carefully pore over the reported details. A quick skim will give you the overall gist.

The story explains how fraud had gone viral at the nation’s largest subprime lender, Ameriquest Mortgage Company. “In court documents and interviews, 32 former employees across the country say they witnessed or participated in improper practices, mostly in 2003 and 2004. This behavior was said to have included deceiving borrowers about the terms of their loans, forging documents, falsifying appraisals and fabricating borrowers’ income to qualify them for loans they couldn’t afford.”

The most important part, the part that explains everything, is not contained within the text. It’s the reaction that ensued thereafter. Nobody cared. Nobody who mattered, anyway. Sure, the article was picked up by the Associated Press and some other papers piggybacked off of the initial reporting by Mike Hudson and E. Scott Rekard. But the gatekeepers of the financial system ignored the story and its broader implications.

Goldman Sachs, Merrill Lynch, Bear Stearns, Lehman and Citigroup were all too happy to continue buying and selling Ameriquest mortgages. Rating agencies continued rating the company’s mortgage bonds, while Standard & Poor’s continued to assign its highest rating to Ameriquest’s mortgage servicing unit. The ultimate vote of confidence came from the bond markets, which demanded no increase in pricing for Ameriquest bonds.

The financial media didn’t really care either. Neither The Wall Street Journal, nor CNBC, nor Forbes, nor Fortune, nor BusinessWeek gave the story much if any play in the year following the story’s release on February 5, 2005.

Most importantly, the heavy hitters in the government didn’t give a damn. Neither the Federal Trade Commission, nor the FBI, nor the Federal Reserve, which was tasked by federal statute to regulate mortgage lending, did anything in response to the story. State regulators in California, where Ameriquest was headquartered, turned a blind eye. Ameriquest was only one company, but its widespread pattern of deceit was emblematic of what was going on throughout the subprime mortgage industry.

The fraud was easy to find if you were willing to look for it. But the gatekeepers were, with very few exceptions,  unwilling to look for it. Remember, 40% of all subprime originations were “low documentation” loans, otherwise known as liar loans.

All this fraud–the forged signatures, the falsified W-2s, the inflated appraisals–spread like a flu virus throughout the different exotic financial instruments, which had triple-A ratings. When the real estate bubble started collapsing, financiers realized that they hadn’t known what was going on all along.

At the end of the day, the cause of the financial crisis was rooted in the government’s refusal to go after crooks, large and small. Fraud was never legal, even when the markets were deregulated. But if the police show no interest in enforcing the law, lawlessness prevails. When the law is aggressively enforced, crime goes down. The murder rate in New York City did not decline because the City Council passed new laws against murder; it went down in large part because of smarter, more proactive police enforcement.

The new legislation on financial reform can have a positive impact, but only to the extent that the government is serious about enforcing the law. Remember, in the aftermath of the savings & loan crisis, Congress enacted the Home Ownership Equity Protection Act of 1994, designed to protect all homeowners from the types of tactics and transactions described in the Ameriquest story. The legislation gave the Federal Reserve authority to modify and update all consumer protections in light of changing circumstances, but Alan Greenspan adamantly refused to take any action whatsoever.


  1. "The new legislation on financial reform can have a positive impact, but only to the extent that the government is serious about enforcing the law. "
    I have to wonder if the folks in DC want any part of this 'enforcing the law' business.
    As 'Jumpstart GSE Reform' has shone they are instead perfectly happy to legislate their way around it ...

  2. Thanks for this reminder David, great reprise.

  3. Thanks for this reminder David, great reprise.

  4. Thanks David for the timely article. So the originators originated junk and collected their upfront fees. The rating agencies gave them AAA ratings. The markets bought the loans. The regulators looked the other way if they looked at all. The DOJ was kept out of the way. And when the house of cards collapsed it put the big hurt on everyone (except for those who did the big short). Who was held accountable and who went to jail? No one.

    And in the years leading up to today the gov has covered up the Fannie and Freddie takeover and expropriation.

  5. Dave is any Truth to the fact that the GSE's have sold off roughly $1 trillion of their retained assets during their conservatorships, and if so where'd that money go?

  6. Off hand I don't know about the sale of retained assets--which are mortgages or FNMA, Freddie Mac & Ginnie Mae securities. In each instance, the GSEs receive cash proceeds for the sale of the assets or the repayment of the loans. Which the GSEs then invest into new assets, which may be mortgages to be held before they are securitized. The flow of funds is very different from earnings that are swept away into Treasury's coffers.

  7. David,

    Can you please analyse the GAO report and dispel the lies that taxpayers took great risk investing $132B in FnF even though FnF never needed toxic investment?

    Posting from TH717:

    Below is the report from GAO to congress on loans made by Feds during 2008 Crisis.
    These numbers are mind boggling.

    Media and anti-FnF propagandists tell a big story that taxpayers risked $187B (including accumulated interest of $55B). But when you compare this investment with loan numbers in GOA reports, the investment in FnF looks like a drop in ocean.

    Also one should not forget that FnF are private shareholders companies for public policy purposes where as most of the companies in GOA report are non-public policy purpose companies also held responsible for fraudulent practices leading to 2008 crisis.

    Interest rates charged to these companies were far less compared to punitive rate charged on FnF. In addition FnF were made to give up 80% equity for free, when the other companies did not have to sacrifice anything.

    FnF have been put under a perpetual conservatorship wiping out investment of FnF shareholders whereas other companies did not have to go thru conservatorship even when many of these companies were capital deficient, illiquid, insolvent and also bankrupt.

    FnF shareholders need to highlight these points when answering anti-FnF people.

    One-time audit of the emergency loan programs and other assistance authorized by the Board of Governors of the Federal Reserve System (Federal Reserve Board)
    during the recent financial crisis